Daily Report for Executives™

Reproduced with permission from Daily Report for Executives, 163 DER, 08/24/2015. Copyright ஽ 2015 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

Ethics

Allegations of a conflict of interest, or even an ‘‘appearance’’ of conflict, is enough to cre- ate a tactical advantage across a wide front of politics. Authors Robert Rizzi and Dianna Muth of Steptoe & Johnson note that one of the most effective traditional defenses to some charges of ethics violations is the insertion of a ‘‘.’’ As a matter of , however, nominees rarely can avoid conflicts by establishing blind trusts. As a matter of optics, on the other hand the trusts retain their value—until, perhaps, they are challenged.

Blind Faith in Blind Trusts: Not as Solid an Ethical Shield as Many Believe

BY ROBERT RIZZI AND DIANNA MUTH ‘‘blind trust.’’ For a number of reasons, the public and many prospective appointees appear to have confidence he government ethics statutory framework is now that, by placing their assets into a blind trust, attacks fully weaponized. The allegation of a conflict of in- under color of the government ethics can be de- T terest, or even an ‘‘appearance’’ of conflict, is flected. In our representation of well over 100 executive enough to create a tactical advantage across a wide branch nominees through the confirmation process in front of politics. Members of both parties and virtually the current and prior administrations, there is an al- all factions have participated in these attacks and it is most universal interest in blind trusts. New clients ask: too late to retreat. Such is modern-day Washington. ‘‘Why can’t I just use a blind trust?’’ In our experience, Surprisingly, one of the most effective defenses to nominees rarely can avoid conflicts by establishing some charges of ethics violations is the insertion of a blind trusts. However, the belief that they are effective has become so entrenched that the actual law on the Robert Rizzi is a partner in Steptoe & John- topic is often ignored in favor of the optics of blind son’s Washington and New York offices trusts. This benefit should not be underestimated. and co-chairs the firm’s tax practice. Mr. Rizzi represents prospective political appointees requiring Senate confirmation through Lifting the Veil the vetting process including Cabinet and sub- When a blind trust is established, the nominee trans- Cabinet members, administrators and com- fers control and management of assets to an indepen- missioners of various agencies, and numerous dent who may not communicate with the nomi- ambassadorial appointees in both Democratic nee regarding the identity of the holdings in the trust and Republican administrations. He also going forward. The theory is that without knowledge of teaches government ethics at Harvard Law what specific assets are in the trust, the nominee could School. not be influenced in the performance of their official Dianna Muth is an associate in Steptoe John- government duties. son’s Washington office who focuses on That law, codified in the Code of Federal Regulations taxation issues for both domestic and foreign (5 CFR § 2634) and interpreted by the Office of Govern- clients and assists clients in tax controversy ment Ethics (OGE), states that (i) financial conflicts can matters at the federal and state level. be prevented only by using a ‘‘qualified blind trust’’ (in turn subject to an array of special sub-rules), and (ii)

COPYRIGHT ஽ 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 0148-8155 2 conflicted assets that are transferred into qualified An Alternative: Discretionary Trusts blind trusts do not lose their taint and are still subject to conflict of interest restrictions until they are sold, be- The rules concerning blind trusts are distinct from cause the government official who has contributed parallel rules regarding ‘‘discretionary trusts.’’ Under a those assets to the trust still has sufficient knowledge of 2008 OGE ruling, assets held in discretionary trusts are the assets to create possible conflicts with official du- not only immune from financial conflicts of interest, but ties. are also exempt from the onerous disclosure rules that First, the trust must meet the criteria to be ‘‘quali- require government officials to list all of their financial fied.’’ For a blind trust to be qualified, OGE insists that holdings on a form (OGE Form 278) available to the the trustee be ‘‘independent,’’ to avoid the possibility public. Under the OGE ruling, discretionary trusts in- for a ‘‘back channel’’ for the to influence man- clude arrangements that provide that a can agement of trust assets. Furthermore, at least for execu- received only so much of the income and principal of tive branch blind trusts, only ‘‘institutional ,’’ the trust as the trustee in his uncontrolled discretion such as banks and other financial service companies, shall see fit, and that deny the beneficiary ‘‘an enforce- can meet the test for true independence. able right to payment.’’ This regulatory requirement is one of many reasons Once again, the logic of the ethics laws on discretion- that qualified blind trusts are so rare. For example, dur- ary trusts makes intuitive sense. An individual who is ing Mitt Romney’s campaign, his limited disclosure of only a potential beneficiary of a , and financial holdings was based in part on the fact that his who cannot compel an actual transfer of trust assets to assets were held in blind trust, even though the trustee herself, has no ‘‘vested’’ interest in the assets. She was his personal lawyer and close friend, and therefore should no more be treated as having a financial interest would have failed the OGE ‘‘independence’’ test. in those assets than she might have in assets that she Whether based upon experience or upon market infor- could at some point in the future inherit from her par- mation, many high net worth individuals are not willing ents, who can always change their wills to allocate to entrust unfettered investment decisions to financial those assets to someone else. institutions as trustees. While a small number of such Thus, government officials who are beneficiaries of institutions have developed a lucrative bespoke practice discretionary trusts are insulated from virtually all fi- acting as institutional blind trustees, the demand has nancial conflicts of interest. However, under a special been relatively modest. qualification in the 2008 ruling, of such trusts are not covered by the exemption. As a result, discre- tionary trusts, while a potential defense for individuals The risks to settlors of ‘‘defective’’ blind trusts are whose ancestors were foresighted enough to set aside assets in trust and grant sole discretion to the trustee, often underappreciated. are not a substitute for blind trusts. Watching the Watchdogs Even if the burdensome requirements are met to es- Interesting questions arise as to how such conflicts tablish a qualified blind trust, the act of transferring are revealed, and to what extent good-government conflicted assets to the trust does not remove their taint. ‘‘watchdogs’’ or other parties can play a role in enforce- This law is logical—if the settlor of the blind trust ment of the government ethics statutes. Political ap- knows what assets are initially transferred into the pointees are required to file annual financial disclo- trust, that knowledge creates the potential for conflicts. sures (OGE Form 278), as well as periodic transaction The fact that day-to-day control is transferred to a reports (OGE Form 278-T). It is these reports that allow trustee does not limit the conflict, under current law. both government ethics officials and the public to moni- Government ethics rules recognize this reality, and only tor potential conflicts of interest. later-acquired trust assets that are not disclosed to the Because the criminal conflict of interest statute only settlor can avoid the risk. requires two elements—knowledge that one holds of a In addition to the difficulties of meeting the onerous financial interest, and participation by the holder in a requirements for qualified blind trusts, the risks to set- ‘‘particular matter’’ (the term of art for official actions tlors of ‘‘defective’’ blind trusts are often underappreci- involving, for example, an adoption of a regulation)— ated. As a general matter, many of the financial conflict government officials who have disclosed their portfo- of interest rules are enforced through federal criminal lios to the public are at risk that some well-meaning law, Title 18 of the United States Code. A failure to government reformers, or not so well-meaning opposi- avoid a financial conflict of interest is not simply a repu- tion researchers from some political faction will allege tational problem (which may be significant enough), a connection to a ‘‘particular matter,’’ and therefore but could lead to a referral to the Department of Justice. bring allegations against the official within the penum- Each year, OGE publishes a list of referrals under vari- bra of a criminal statute. The blind trust, of course, ous criminal ethics laws, including under the relevant serves as a shield by allowing the appointee to disclaim provisions of 18 USC § 208, and the prospect of appear- knowledge of the financial interest. ing on that list is enough to cause many to proceed cau- The consequences of conflicts of interest can reach tiously. beyond criminal liability for the appointee and dispar- If a blind trust becomes defective by failing to meet aging press coverage. the regulatory requirements—the blind trust is ‘‘blown In United States v. Mississippi Valley Generating Co., up’’—the settlor is immediately exposed to the risk of a the Supreme Court, in an opinion by Chief Justice Earl conflict of interest for the assets in the trust, and there- Warren, held that a flagrant conflict of interest permit- fore to criminal liability. ted the government to disavow a tainted , and

8-24-15 COPYRIGHT ஽ 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. DER ISSN 0148-8155 3 left the counterparty without recourse and with sub- will delegate control over investment decisions, in re- stantial out-of-pocket costs. The case involved a mid- turn for a (hopefully) higher than market yield at the level bank officer of First Boston (now Credit Suisse), end of the fund’s term. To suggest that they might make who had volunteered to help the Bureau of the Budget decisions in government that could affect their limited (now OMB) analyze bond financing for a utilities priva- partner investments does not comport with their basic tization transaction, where the bank was to be paid a understanding of how such funds work. A similar logic fee by the utility in connection with the same transac- would apply to decisions made by trustees of blind tion. trusts. Even though neither the bank nor the individual em- Finally, most of the individuals entering government ployee ultimately profited from his overlapping activi- service from successful private-sector careers do not ties, and although the government had participated in envision staying in government forever. The use of a all aspects of the transaction and knew about the role blind trust to hold assets only while the settlor spends a of the bank officer, the Court decided that voiding the couple of years in Washington comports with this view. contract was necessary to send a message that ‘‘no man This view also highlights the difficulty of matching ex- can serve two masters’’ (the Biblical admonition was ac- pectations with government ethics laws, which in a tually used in the opinion). The price of a later- given case may impose a permanent reallocation of in- discovered conflict of interest can be substantial. vestment assets for individuals entering government Despite these risks and drawbacks, confidence in service, even if their tenure will be temporary. blind trusts continues virtually unabated, through elec- It is also possible that the popular confidence in blind tion cycles and scandals. trusts derives from a lack of familiarity with how such vehicles actually operate. Although simple ‘‘family’’ What Accounts for this Blind Faith? trusts are becoming increasingly common as a means of avoiding costs of administration, complex There are number of possible explanations for the trusts are not a common feature of Middle American blind faith in blind trusts. Historically, blind trusts were portfolios, and the concept of a privately operated widely used, and prior to the promulgation of the Ethics ‘‘blind’’ trust vehicle can be comforting to a public gen- in Government Act, such arrangements were a routine erally suspicious of the conduct of government officials. solution to avoid conflict of interests. Faith in blind A similar confidence often attaches to law firm ‘‘ethical trusts has been reinforced by high-profile examples of walls’’ to address potential legal conflicts in large law politicians who have used such trusts in the past. Mitt firms. In both cases, the ‘‘blind’’ vehicle operates rea- Romney carried on a long tradition of presidential can- sonably well and permits a degree of flexibility in the didates, including Ronald Reagan, who famously held system, blessed in each case by lawyers. assets in a blind trust throughout his presidency. The use of presidential trusts, and the widespread Will the Cynics Notice? publicity they receive, no doubt reinforces the popular perception that such measures ‘‘work.’’ Presidential Like most matters of faith, respect should be shown, blind trusts are themselves ironic, because by statute, and the mystical confidence in the ability of blind trusts both the president and the vice president are exempt to defend against conflict of interest charges must be from the criminal conflict of interest statutes. Presiden- acknowledged. The fact that the general public contin- tial blind trusts are largely ceremonial. ues to believe in these exotic vehicles as protections Another possible explanation is that faith in blind against conflicts of interest reinforces one of the main trusts reflects the views of successful high net-worth in- objectives of the government ethics laws, that is, pro- dividuals from the private sector (i.e., many of the moting ‘‘trust in government’’ by combatting even the nominees with possible exposure to financial conflicts) appearance of conflicts of interest, and seems to coun- that these devices ‘‘should’’ work. Based on our experi- teract the general cynicism concerning Washington. ence, many wealthy investors who actively manage Despite the fact that there is almost no basis for that their own portfolios may assume that, if their ability to faith in the law, officials may well continue to use blind buy and sell is eliminated, that should be enough to trusts to avoid politically-charged attacks couched in avoid potential conflicts once in government. Many of terms of alleged violations of government ethics laws. these individuals in particular tend to equate active Under these circumstances, blind trusts serve a pur- management with potential conflicts. pose, even if they do very little actually to prevent con- For example, it is quite common for potential nomi- flicts of interest. nees to make sharp distinctions between limited part- Blind trusts formed for purposes of persuading the ners and general partners who participate in private in- public that government officials took formal steps to vestment funds—they are well aware that the deal avoid conflicts may be the next evolution in battles over struck in such funds is that, as limited partners, they government ethics.

DAILY REPORT FOR EXECUTIVES ISSN 0148-8155 BNA 8-24-15